An American Perspective from China

Europe Looks to China

First of all, a personal note and quick explanation: last week, I had a medical emergency — nothing life-threatening, but enough to put me in the hospital and lay me low for a while. I’m slowly on the mend, but for the past week I have had neither the energy nor the focus to author any blog posts, although I have been trying my best to keep up with the news. So apologies for being “radio silent” while so many interesting things have been going on.

The news these past couple of days has been dominated, of course, by the efforts of European Union leaders to reach a bailout agreement — and the fact that, immediately after the outlines of such an agreement were reached, the first thing the EU did was dispatch an envoy to Beijing, to persuade China to help fund the plan. Arvind Subramanian, a scholar at the Peterson Institute and author of a new book called Eclipse: Living in the Shadow of China’s Economic Dominance (which argues, among other things, that the Renminbi will emerge as a global reserve currency sooner than anyone expects), caught the mood of the moment with a prominent op-ed in the New York Times titled “Why China Should Bail Out Europe.” In it, he argues that China’s moment as a Great Power has arrived: that it can and should save Europe, and in doing so, ought to demand political and economic concessions, including a dominant role in running the International Monetary Fund:

China should demand nothing less than a wholesale revamping of the governance of the I.M.F. to reflect the current economic realities. Governance reform can no longer be just about the nationality of the I.M.F.’s managing director but should fundamentally be about who will have the greatest voice and exercise the most power in the new world . . . Supplicants, China should insist, cannot have veto power in a financial institution. The Chinese government could then trumpet a nationalist achievement — equal status as the United States, and a greater status than that of Europe, in running the world’s premier financial institution — as the return for investing its cash abroad.

I haven’t had the chance to read Subramanian’s book in full (although I look forward to doing so), so I’m not going to undertake here to rebut his broader thesis. But in this particular instance, China’s role in the EU bailout, I find his take — which admittedly seems to be the prevailing interpretation among both European leaders and their publics — more than a little misconceived. I’ve expressed this before, but let me restate it again:

Many people inside and outside of China are of the mistaken impression that China’s $3 trillion in FX reserves make it a massive investor in US Treasuries, Euro sovereigns, etc. at its own discretion, able to turn on or off the flow at will and therefore requiring to be courted and appeased. In fact, unless China (wisely in my view) were to consciously break its dependence on exports and captive savings, it must accumulate ever-growing reserves and has little choice but to put them somewhere.

Some media accounts make it seem like China could single-handedly recapitalize European banks and bond markets, by deploying its $3 trillion reserves, should it choose to do so. In truth, China can’t reallocate the deployment of those reserves (among currencies or recipients) to any sizable extent without also reallocating the global payments imbalances they reflect and support. Shift your reserves from dollars to euros, shift your holdings from the U.S. to Europe, and you shift your trade/capital flow surpluses with it.

Those who are looking to China as a short-term savior for Europe would do well to ask themselves why China has such a ready pool of investable cash on hand. It does so because it runs a chronic surplus with most EU countries (besides Germany and Ireland) much like it does with the U.S. China produces more than it consumes, the US and most of the EU consume more than they produce — hence their growing dependence on debt. The ultimate solution to the EU debt crisis is not more debt, but growth, so countries can earn their way out of debt. Certainly there are internal imbalances at work in Europe (Germany’s surpluses with the rest of the EU) but China’s surpluses, and its reserve accumulation, are part of Europe’s growth deficit, part of the underlying problem.

If China really wants to do European countries a genuine favor, the best way is not to continue running surpluses with the EU, then turning around and lending the proceeds back to the Europeans to keep them on life support. It is to use the proceeds from what China sold to Europe, or received as investment from European companies, to buy European goods and/or make productive investment in Europe, thereby generating jobs, growth, and earnings that can get Europe back on its feet and back buying Chinese-made goods on a more sustainable basis. But that would require a significant mental and policy shift from China’s current growth paradigm.

Such a shift, however, would be squarely in China’s own interests, not just that of its trading and investment partners. The popular, conventional view sees China as a vastly wealthy bank sitting on a pile of money, and the deficit nations of the US and EU as “supplicants” (as Subramanian puts it) desperately hoping that bank will lend them some. In fact, China is more like a shopkeeper who keeps allowing his customers to run up higher and higher tabs on credit, for fear that if he doesn’t, they won’t be able to keep buying and he will go out of business. That certainly isn’t good for the customers, who end up getting into greater and greater debt, but it isn’t a particularly good position for the “creditor” to be in either.

I have heard some argue, in reaction to Subramanian’s op-ed, that China participating in the EU bailout would somehow hasten the acceptance and credibility of the Renminbi as an “international” currency — a key development Subramanian sees as heralding the dawn of Chinese economic and political supremacy. Regarding that goal, however, I would rank, in order of importance, the following as far greater priorities and/or obstacles:

1) Giving people outside of China some way to earn and accumulate RMB by becoming a net exporter rather than massive net importer of currency (i.e., running a balance of payments deficit, either on the current or capital account)

2) Making the RMB “useful” for far more than a highly constrained/regulated set of purposes (i.e., freely convertible)

3) Offering those who do earn RMB somewhere to hold them until they want to use them (i.e., developing deep, liquid, transparent, and freely accessible capital markets, particularly bond markets).

I would not rank recycling China’s surpluses as debt-financing for deficit countries, which it is already doing and must do in any event, high on that list — even when it appears to be extending much-needed “help” in a crisis. In fact, the “help” that China is able to extend — its massive accumulation of dollars and other hard currencies — is itself testament to the marginal status of the Renminbi in China’s own international trade and investment transactions, much less the world’s.

It is entirely possible that China will declare, in response to European entreaties, that it will deploy some fraction if its annual balance of payments surplus — say $50 billion — to support the European bailout fund or bond markets. Such an allocation — which it may well have had to make anyway, given its ongoing accumulation of reserves — will no doubt win it media kudos and perhaps favors from a grateful Europe. For China, the optics will be fantastic, and the widespread misunderstandings regarding China’s role will only exaggerate, rather than diminish, the political and PR benefits for the Chinese as “saviors.”

The reality, though, is a long way from China “saving” Europe. Not that I disagree with involving the Chinese — it is a good idea to involve China as a “responsible stakeholder” in organizing a response to any crisis that affects the global economy. But if China truly wants to be a “responsible stakeholder,” the most responsible step it could take would be genuine movement towards a more sustainable balance of trade and investment. That means not merely a more market-based approach to currency exchange rates — the U.S. Senate’s current obsession — but far more importantly, a renewed commitment on China’s part to market openness, even regulatory playing fields, and freer capital flows.

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Given that roughly a quarter of China’s forex reserves are in euro-denominated assets and that sections of domestic public opinion (or, rather, of the CCP) are obsessed with maintaining the value of those reserves, would Beijing have any choice but to chip in if it looked as though the euro was on the brink of total collapse? It may stand aside this time, but the failure so far of Eurozone governments to address the fundamental causes of the crisis suggests such a decision has merely been deferred. But then, if it did come to the euro’s aid, would it not simply be throwing good money after bad? In its efforts to diversify away from US assets, Beijing may simply be digging another hole for itself on the other side of the Atlantic. Isn’t life unfair?

The whole Laurel and Hardy scenario (“Well, here’s another nice mess you’ve gotten me into!)” is played out perfectly by western nations who have allowed unions to make manufacturing industry so costly that they export manufacture to countries with no unions. Sooner or later the circle is completed and people in both economies realise they have been duped. That is what is happening in China and in USA and EUR today.

China is paid in USD and EUR for the vast majority of its outputs. It cannot spend all the revenue as it comes in so it is obliged to “safeguard” the funds in treasuries of one sort or another. The consuming nations borrow more to pay the supplier and their debt instruments lose value to the supplier. To keep the supplier happy they must continue to buy, but now the supplier must fund the purchase. The carousel never comes to a stop, but unless the riders switch horses to balance the ride, it will fall over.

For the benefit of all interested parties, China must spend its accumulated funds in education, infrastructure and healthcare. Europe must earnestly share its capacity to contribute to quality of infrastructure and social welfare in China, while America must cast off its Reds-under-the-beds mentality and look upon China as a commercial ally, not a political adversary.

All the parties involved need to adopt a more mature approach to economic reality, and separate social politics from the equation.

In our present circumstances, nothing in history has prepared us for potential outcomes. For perhaps the first time in millennia, we have within our reach the opportunity to tell history to f*** off.

“For the benefit of all interested parties, China must spend its accumulated funds in education, infrastructure and healthcare.”

I think Prof. Chovanec explained above that this isn’t possible. Using the same analogy above, it would be like the shopkeeper using the tab his customers owe him to buy a new cash register.

Reducing the enormous trade surplus, either by encouraging more imports or allowing the RMB to appreciate, would give Chinese citizens more purchasing power, which would probably enhance social welfare more than any targeted government program would.

“Given that roughly a quarter of China’s forex reserves are in euro-denominated assets and that sections of domestic public opinion (or, rather, of the CCP) are obsessed with maintaining the value of those reserves, would Beijing have any choice but to chip in if it looked as though the euro was on the brink of total collapse? ”

This is the international economy we live in. Beijing wouldn’t lift a finger if there wasn’t something in it for them. Beijing does not want a global meltdown, just as they don’t want the US to crash (again), and they don’t want to see the USD crash. For that, we should all feel a little safer, that China has a vested interest to pitch in.

What you said makes sense, but for China to buy or import goods from others needs a big change in their mindset. The problem with China in international trade is, it tends to behave more like a predator. It wants to export as much as it can but not interested in importing from others. What China is interested is in extracting or getting more raw materials which are relatively lower value-added, causing most countries to be on the losing side when trading with China.

Actually, China has already been investing in some Greek fixed assets. I think China will be more keen in investing in those real fixed assets than to invest in those junk government bonds. The problem is whether Europeans are comfortable in allowing China to ‘buy’ a big part of them? Otherwise, I really don’t think China will be of much help, maybe just a token support, as a sort of posturing.

Hi Patrick,
Hope you are feeling better. I saw this quote in a SCMP article and would be interested in your thoughts…

“Finance.21cn.com, a financial information website, quoted Dr Yin Jianfeng , deputy director of the Chinese Academy of Social Sciences’ institute of finance and banking, as saying that for China, setting conditions for Europe was not only prudent but a must.
China’s holding of any European bonds must be backed by adequate collateral, and must be denominated in yuan, he said.”

EU bonds denominated in RMB. Hmmm. How would that work mechanically? Europe would be borrowing in a currency that not only does it not own but one that is controlled and not freely traded? So China would liquidate its EU investments or sell its US dollars for euros in order to buy the bonds. The bonds would be repaid in RMB, generated how? By Europe running a trade surplus with China? That’s what China doesn’t want. By using euros or dollars or some other currency to buy RMB? Wouldn’t that bid up the RMB and make China’s imports more expensive? Or would China print more RMB to meet the demand, maintaining its managed exchange rate. Assuming they keep these RMB off the mainland market (cancelling out the RMB asset and RMB liability from the PBOC balance sheet), they still end up with euros on the asset side of the balance sheet. Not sure what denominating the bonds in RMB does for China.

There will obviously be a lot of Greek assets for sale as part of an attempt to return the government to a sustainable path of balanced revenue and expenditure (although unsurprisingly the Greek privatisation programme is already behind schedule). Probably the same with Italy also. Will be interesting to see if the Chinese can successfully make and win bids for Greek mobile phone networks, toll-roads, recapitalised banks and other cash-generating state-owned assets, in addition to merely coughing up for EFSF-issued debt, as part of an integrated Eurozone support package. This works as well as importing more European goods in terms of addressing capital flows and probably better in terms of “involving China as a responsible stakeholder”.

I can imagine it would be pretty indigestible for Greek public servants, Eurozone voters etc and probably fuel on the fire for US’s China alarmists but this kind of action is not unprecedented – US PE funds and Singapore’s SWF Temasek did some pretty good bargain-hunting during the IMF-sponsored bail-outs in Korea, Indonesia and Thailand in 1997/ 1998.